The Choice of Interest Rate Models and Its Effect on Bank Capital Requirements Regulation and Financial Stability

Abstract

According to the Basel regulation banks may use internal risk models to measure interest rate risk and calculate regulatory capital requirements. Under its pillar II the Basel framework grants leeway to banks in their choice of these models. We therefore focus on how well interest rate models describe real interest rate movements empirically and which impact the model choice has on the economic value of bank equity during the financial crisis. Furthermore, we address the question how different choices of interest rate models affect the overall financial stability. To this end we estimate eight different interest rate models for three different currencies (USD, EUR, CHF) using the Generalized Method of Moments (GMM). Then we approximate the balance sheet of a typical Swiss bank during the financial crisis and run Monte Carlo simulations of the balance sheet using the estimated interest rate models. Our results show that the required economic value of equity for a bank varies considerably with the different choices of interest rate models. However, the interest rate models which are empirically best fitting do not imply aggregate financial stability. Thus, banks’ choices of interest rate models to calculate regulatory capital requirements may have a crucial impact on overall financial stability.

Extension of Short Rate Model Under a Lévy Process

“…In this section, the Hull-White short rate model is extended from a process driven by a Brownian motion to a process with the ability to capture different jumps that occur due to unexpected happenings in real-life situations. Thus, the modified model will help in selecting a better model in financial markets (Lang et al, 2018) Let the short rate dynamics be given by 𝑑𝑟 𝑡 = (𝛽 − 𝛼𝑟 𝑡 )𝑑 𝑡 + 𝜎𝑑𝑋 𝑡 (3.1) where 𝑋 𝑡 denotes the special class of Lévy process called a variance gamma process. Solving the dynamics gives…”